Unit 3 · Prices, Controls and Market Failure

In June, strawberries at a farm stand near Kankakee sell for about $3 a pound. Suppose a late frost wipes out half the local crop. Within a week the price at the stand is $6 a pound. Nobody held a meeting to set that number. The higher price appeared because many buyers were chasing far fewer berries. That price is now doing three jobs at the same time.

First, the price is a signal. A $6 tag tells every grower in the country that strawberries are in short supply in Illinois. A farm in a warmer state that was going to sell its berries locally now ships a truckload north instead. Second, the price rations. At $3 the stand sold about 1,000 pounds a day. At $6 the buyers who wanted berries for a single snack drop out, and daily sales fall to about 600 pounds. The limited berries go to the people who value them most, as measured by what they will pay.

Third, the price motivates. The chance to earn $6 a pound pushes growers to replant damaged rows, water more carefully and pick fields that were not worth picking at $3. Over the summer, extra supply arrives and the price drifts back down. No one was ordered to do any of this. The price carried the information and the reward in one number. When a government freezes a price, all three jobs stop working, and this chapter is about what happens next.

Think about used bikes in a college town in August. Here is a labeled example schedule. At $100, students want 90 bikes but only 30 owners will sell. At $150, buyers want 70 and sellers offer 50. At $200, buyers want 60 and sellers offer 60. At $250, buyers want 50 and sellers offer 70. The price where the two numbers match, $200 and 60 bikes, is the equilibrium. Economists say the market clears at that price: every buyer who wants a bike at $200 finds a seller, and every seller who wants to sell at $200 finds a buyer.

Now suppose sellers try $250. They offer 70 bikes but buyers take only 50. The extra 20 bikes are a surplus. Sellers with unsold bikes cut their asking price to attract a buyer, and the price falls toward $200. Suppose instead the price starts at $150. Buyers want 70 bikes but only 50 are offered. The missing 20 bikes are a shortage. Buyers who cannot find a bike offer a little more, sellers notice, and the price rises toward $200.

Notice what a shortage is and is not. It is not the same as scarcity. Bikes are always scarce; there are never enough for everyone to have one free. A shortage is a gap between what buyers want and what sellers offer at one particular price. A free-moving price closes that gap by itself. A shortage lasts only when something stops the price from rising. In the rest of this chapter, that something is usually a law.

A price ceiling is a legal maximum price. Sellers may charge less but not more. Go back to the used-bike schedule from the last lesson, where the market clears at $200. Suppose the city council decides bikes are too expensive for students and passes a rule: no used bike may sell for more than $150. At $150, buyers want 70 bikes and sellers offer 50. The rule has manufactured a shortage of 20 bikes that did not exist before.

The word to remember is binding. A ceiling binds only when it sits below the equilibrium price. Suppose the council had set the ceiling at $250 instead. The market clears at $200, which is already under the cap, so nothing changes. Students sometimes picture a ceiling as something above the market, because a ceiling in a room is above your head. In economics the effective ceiling is below equilibrium, holding the price down like a lid. A ceiling above equilibrium is called non-binding.

What happens to the 20 students who want a bike at $150 but cannot get one? The price is no longer allowed to ration, so something else will. Some students will camp out at the bike shop early. Some sellers will keep bikes for friends. Some will quietly sell for $220 in a parking lot. Sellers who must accept $150 may stop fixing brakes or replacing tires before a sale, because the lower price does not pay for the work. Every one of these results shows up wherever a ceiling binds, from apartments to gasoline.

Imagine a city where the market rent for a one-bedroom apartment is $1,500 a month and 10,000 such apartments are rented. Rents have been climbing, and voters pass rent control: no landlord may charge more than $1,000. Here is a labeled example of what happens. At $1,000, renters want 12,000 apartments. Landlords, however, will offer only 9,000; some convert units to condos, some stop renting a basement unit, some sell. The shortage is 12,000 - 9,000 = 3,000 apartments.

The shortage grows with time. In the first year, most buildings already exist, so supply barely changes. Economists say short-run supply is inelastic. But over ten years, builders decide not to put up new rental buildings when the rent cannot cover the cost. Owners skimp on paint, heat and repairs, because a full waiting list means a leaky faucet will not cost them a tenant. The 3,000-unit shortage may double. Meanwhile newcomers, young workers and people who move for a job cannot find a place at all, while a lucky tenant in a controlled unit stays put for decades.

This is a case where the arguments deserve a fair hearing on both sides. Supporters say rent control protects long-time residents from sudden rent spikes, keeps neighborhoods stable and prevents families from being pushed out of the city they grew up in. They point out that building takes years and tenants need help now. Critics answer that the control helps only those who already hold a lease, shrinks the supply of housing and lowers its quality, and that the real fix is to allow more building. Most economists lean toward the critics on the supply question, but many also support other tenant protections such as help with moving costs or rent vouchers, which do not cap the price.

The chapter opened with drivers waiting ninety minutes for ten gallons. Here is the same story in the language you now have. In 1973 world oil supply fell, so the supply curve for gasoline shifted left. In a free market the price would have jumped to a new, higher equilibrium. Fewer people would have driven, more would have carpooled, and the smaller amount of gasoline would have been rationed by price. There would have been complaints about the price, but no lines.

Instead, federal rules held the price at the pump below that new equilibrium. Suppose, as a labeled example, the controlled price was $0.40 a gallon while the market-clearing price would have been $0.60. At $0.40, drivers wanted more gasoline than refiners could deliver. That gap was the shortage, and it took the form of lines, limits per customer and stations with no gas at all. The price could not do its rationing job, so time did it instead. Waiting in line was a cost, but one that went to nobody. Nobody got paid for the hours that drivers sat idling.

When the controls were lifted in the early 1980s, the price rose to where the market cleared, and the lines disappeared even though oil was no more plentiful. The lesson is not that high prices are pleasant. It is that a price control does not create more of a scarce good. It only changes how the scarce good gets divided, from willingness to pay to willingness to wait. Any policy that wants to help drivers has to either increase supply or accept some other way of choosing who gets the gasoline.

A price floor is a legal minimum price. Sellers may charge more but not less. Here is a labeled example for a dairy market. Milk clears at $3 a gallon, where 1,000 gallons a day are bought and sold in a small city. Farmers complain that $3 does not cover their costs, and the state sets a floor of $4. At $4, farmers supply 1,200 gallons, because the higher price makes it worth milking more cows. Shoppers, facing $4, buy only 900 gallons. The result is a surplus of 1,200 - 900 = 300 gallons a day.

Just like a ceiling, a floor only matters when it is on the binding side of equilibrium. A floor at $4 binds because it is above the $3 clearing price. A floor at $2 would be non-binding: the market already trades at $3, so a rule saying the price may not fall below $2 changes nothing. Students often mix this up, so say it twice. Ceilings bind from below. Floors bind from above.

Who deals with the 300 extra gallons? In a free market the price would fall until the milk cleared, but the floor forbids that. So either the milk spoils, the government buys it, or farmers find some other way to compete for the buyers who remain. They might offer free delivery or coupons, which quietly lower the real price. Every binding floor produces a surplus, and every surplus needs an answer. The next two lessons look at the two most famous floors in the American economy: the minimum wage and farm price supports.

A wage is the price of an hour of work. In the labor market, workers are the sellers and employers are the buyers, so the picture flips from a normal market: households supply labor and businesses demand it. The federal minimum wage has been $7.25 an hour since 2009. Illinois raised its own minimum in steps, reaching $15 an hour in 2025. A minimum wage is a price floor, and the tools from the last lesson apply.

Here is a labeled example for one town. Suppose the market wage for entry-level restaurant work would clear at $12 an hour with 1,000 jobs. The state sets a floor of $15. At $15, employers want only 900 workers; a few restaurants cut hours, install ordering kiosks or close a slow lunch shift. At $15, more people want those jobs, say 1,100, because the pay is better. The gap of 1,100 - 900 = 200 is a surplus of labor, which in a labor market has another name: unemployment. The 900 who keep their jobs earn $3 more an hour. The 100 who lose a job, and the 100 new job seekers who cannot find one, are worse off.

That is the model. The debate is about how big the numbers really are. Critics of a high minimum wage argue that job losses fall hardest on teenagers and workers with the least experience, that employers respond with fewer hours and higher prices, and that a large jump speeds up automation. Supporters argue that many employers have few competitors for local workers and were paying less than workers were worth, so a moderate floor can raise pay with little job loss. They also point to studies of neighboring states with different minimums that found small employment effects. Both sides agree on one thing: a floor set far above the market wage, say $40 an hour, would destroy many jobs. The disagreement is about moderate increases, and the evidence is genuinely mixed.

Illinois is one of the nation’s largest producers of corn and soybeans, so farm prices matter here. Since the 1930s the federal government has used many programs to hold up crop prices, starting with the Agricultural Adjustment Act of 1933. One classic tool is a price support: the government promises to buy a crop at a set price, which acts as a floor. If the market price falls below the support, farmers sell to the government instead.

Here is a labeled example. Suppose wheat would clear at $4 a bushel with 100 million bushels traded. The government sets a support price of $5. At $5, farmers grow 110 million bushels, but millers and bakers buy only 90 million. The surplus is 110 - 90 = 20 million bushels, and the government has promised to buy it. The bill is 20 million × $5 = $100 million, paid by taxpayers. Then the wheat has to be stored, given away or sold abroad, and each choice has its own cost. Consumers also pay more at the bakery, because bread now uses $5 wheat instead of $4 wheat.

Supporters of farm supports argue that farm prices swing wildly with weather, that a bad year can wipe out a family farm, and that a steady food supply is a national interest. Critics reply that the biggest payments go to the largest farms, that the programs encourage growing crops nobody wants, and that direct insurance against bad harvests would protect farmers at lower cost. Today most U.S. farm programs use crop insurance and payments tied to low prices rather than government purchases, but the logic of the floor and the surplus is the same.

When a ceiling binds, more people want the good than can have it, and the price is not allowed to sort them out. So other rules take over. The oldest is first come, first served: a queue. It feels fair, but it rations by time instead of money, and time is a real cost. Suppose gas is $0.20 a gallon cheaper under a ceiling than it would be in a free market, and a driver buys 10 gallons after waiting two hours. She saved $2 and spent two hours doing it. That is a return of $1 an hour, far below what most people earn. The saving is real, but the hours are simply lost; no seller receives them.

A lottery rations by luck. It is cheap to run and hard to game, but it sends no signal and gives no reward for producing more. Concert tickets and some city housing programs use it. Ration coupons were the World War II approach: each family received a book of stamps for sugar, meat, gasoline and tires, and a purchase required both money and a stamp. Coupons can direct goods to everyone equally, but they take a large bureaucracy and invite trading and forgery.

The least fair method is favoritism. When a landlord has forty applicants for one controlled apartment, he can pick his cousin, or the applicant who slips him cash, or the one whose last name he likes. Rationing by connections rewards who you know instead of what you offer. Notice that all four methods share a weakness the price system does not have. None of them tells producers to make more, and none rewards them for doing so. Non-price rationing divides the existing pie; only price grows it.

Go back to the used bikes with a $150 ceiling and a 20-bike shortage. A student who badly needs a bike and a seller who badly wants more than $150 can both do better by breaking the rule. They meet in a parking lot; the student pays $260 in cash, more than the old $200 equilibrium, and the seller hands over the bike with no receipt. That trade is part of a black market: buying and selling at a price the law forbids.

Why $260 and not $200? Because the legal market has soaked up 50 bikes at $150, and the buyers left over are competing for whatever leaks out from under the ceiling. Sellers also charge extra for the risk of getting caught. Black-market prices under a ceiling are usually above the old free-market price, not below it. The control that was meant to make bikes cheaper has made some of them more expensive.

Black markets appear under floors too. A worker who cannot find a job at the $15 minimum may agree to work for $10 in cash, off the books. Both sides break the law, and the worker gives up every legal protection: no record of hours, no unemployment insurance, no recourse if the boss refuses to pay. Rent-controlled cities see key fees and unofficial sublets at double the legal rent. Ticket ceilings produce scalpers outside the arena. The pattern is always the same: a gap between the legal price and the price people would actually agree on, and someone willing to fill it for a fee.

Suppose a state adds a tax of $1 per gallon on gasoline and requires stations to send the money in. Students often assume the station pays the whole dollar. Watch what actually happens in a labeled example. Before the tax, gas sells for $3.00. Stations now need $1 more per gallon to earn what they earned before, so they try to raise the price. But at $4.00 some drivers cut back, so stations cannot pass the whole dollar through. The price settles at $3.60. Drivers pay $0.60 more than before. Stations collect $3.60, send $1 to the state and keep $2.60, which is $0.40 less than before. The dollar is split: 60 cents on buyers, 40 cents on sellers.

Economists call this split the incidence of the tax. The rule is simple. The side that can least escape the market bears more of the tax. Drivers cannot easily stop buying gas to get to work, so their demand is relatively inelastic and they carry the larger share. If demand for a good were very elastic, meaning buyers would abandon it at the first price increase, sellers would have to absorb most of the tax instead. The name on the tax form does not decide who pays. The elasticities do.

A subsidy is a tax in reverse: the government pays money per unit instead of collecting it. If the state paid $1 per gallon to stations, the price would not fall by a full dollar. In the same market it might fall by $0.60 to $2.40, with drivers gaining 60 cents and stations keeping the other 40 cents. Again the less elastic side, the one that would keep buying anyway, captures the larger share. This is why a subsidy meant for buyers can end up largely in sellers’ pockets, and why economists always ask who really pays rather than who writes the check.

In the last chapters, a free market price did three jobs well: it signaled, it rationed and it motivated. Underneath that success was a quiet assumption. The price of a good was supposed to reflect everything it cost to make and everything it was worth to have. When that assumption holds, the market amount is the right amount. Every unit that is worth more than it costs gets made, and nothing else does.

A market failure is a situation where that assumption breaks. The price of paper from the Riverton mill included wood and labor but not the poisoned river. The price was too low, so the mill sold too much paper. In other cases the price leaves out a benefit instead. A flu shot protects the person who gets it and also everyone she would have infected, but she pays for only her own protection, so too few people get the shot. Market failure does not mean the market collapsed. It means the market worked exactly as designed and still arrived at the wrong amount.

This chapter covers four main causes. Externalities are costs or benefits that spill onto people outside the transaction. Public goods are things like national defense that a market will not provide because nobody can be made to pay for them. Common resources, like fish in a lake, get overused because nobody owns them. And imperfect information lets one side of a deal know something the other side does not. For each one, you will see the failure in numbers first, then the standard tools governments use to repair it, and then the limits of those tools.

Put numbers on the Riverton mill. Suppose it costs the mill $10 to make a ton of paper, counting wood, labor and machines. That is the mill’s private cost. Each ton also does about $4 of damage to the town downstream. That $4 is an external cost, because it falls on people outside the deal. The full cost to everyone, $10 + $4 = $14, is the social cost. The mill sees only the $10, so it happily sells paper for $12 and makes 1,000 tons a week. From society’s view, each of those tons costs $14 and sells for $12; the mill is producing tons that are worth less than they truly cost.

Now think about the supply curve. The mill’s supply curve is built from its $10 private cost. If the mill had to pay the $4 too, its supply curve would sit $4 higher at every quantity. At that higher curve, fewer tons are worth making. Suppose the mill would make only 700 tons a week if it faced the full $14. Then the market, left alone, produces 300 tons too many, and each of those 300 tons hurts the town more than it helps anyone. That gap is the size of the market failure.

The classic examples of negative externalities all fit this shape: smoke from a power plant, noise from an airport, traffic from one more car on a crowded highway, a neighbor’s untreated yard spreading weeds. In every case the producer sees a cost that is too low, so the quantity is too high. Notice that the goal is not zero. Riverton would not want the mill closed; 400 jobs and paper at $12 are real benefits. The goal is the amount the town would choose if it were paying the full cost, which in this example is 700 tons, not 1,000 and not 0.

A flu shot at a Chicago pharmacy costs $30. Suppose Jamal figures the shot is worth about $25 to him: fewer sick days, less misery. He skips it. But Jamal rides the Blue Line every day. If he catches the flu, he will probably pass it to two or three riders, and each of them may pass it on. The protection his shot gives to strangers is worth something like $15. The shot’s social benefit is $25 + $15 = $40, which is more than the $30 price. Society would want Jamal vaccinated. Jamal, counting only his own $25, says no.

This is a positive externality: a benefit that spills onto people outside the deal. Because buyers weigh only their private benefit, demand is too low and the market produces too little. The mirror image of the mill: there, the supply curve was too low because of a hidden cost; here, the demand curve is too low because of a hidden benefit. Education is the biggest example. A student who finishes high school earns more, which is her private benefit. She also becomes a more informed voter, a more productive coworker and a less likely user of public aid, which benefits everyone else. That spillover is the standard economic case for public schools.

The standard fix runs in reverse from a tax. If the state pays $10 of Jamal’s shot, the price to him falls to $20, below his $25 private benefit, and he gets vaccinated. The state has used a subsidy to add the external benefit back into his decision. Public subsidies for vaccines, K–12 schooling, college grants and research all rest on this logic. The open question is always the size of the spillover. If the external benefit of a good is small, the subsidy mostly rewards people for what they would have done anyway.

Back to Riverton. The state has three classic tools. The first is a corrective tax: charge the mill exactly the external cost, $4 per ton. Now the mill’s cost is $14, the same as the social cost. It cuts output from 1,000 tons to 700 on its own, because the last 300 tons no longer pay. Nobody had to tell the mill how much to make; the price did the work. The tax also raises money, in this case 700 × $4 = $2,800 a week, which could help pay for Riverton’s water plant. Economists tend to like corrective taxes because they let each polluter find its own cheapest way to cut back.

The second tool is regulation: a rule that says the mill may dump no more than a set amount, or must install a filter. Rules are simple to understand and to enforce, and they work even when the state cannot measure the damage in dollars. Their weakness is that one rule fits everyone. A mill that could cut pollution cheaply and one that could only cut it at great expense face the same requirement, so the total cleanup costs more than it needs to. Rules also give no reward for doing better than the limit.

The third tool is the courts. If Riverton owns the right to clean water, it can sue the mill for damages, and the threat of paying $4 a ton has the same effect as the tax. Sometimes the two sides can simply bargain: the town might pay the mill to install a filter if that is cheaper than a lawsuit, or the mill might pay the town for the right to dump a limited amount. Bargaining works well when the parties are few and the harm is clear. It works badly when thousands of people are affected and the cost of getting them all to agree is enormous, which is why air pollution across a whole city is usually handled by taxes or rules instead.

Suppose two power plants each emit 100 tons of a pollutant a year, and the state wants the total cut from 200 tons to 120. It could order each plant to cut 40 tons. But the plants are different. Plant A has an old boiler and can remove a ton for $200. Plant B is already modern and can remove a ton only at $500. Equal cuts cost A 40 × $200 = $8,000 and B 40 × $500 = $20,000, a total of $28,000.

Now try cap and trade. The state prints 120 permits, each allowing one ton, and gives 60 to each plant. A plant may emit only as many tons as it holds permits, but permits can be bought and sold. Plant B looks at its $500 per ton cleanup cost and would rather buy permits. Plant A can clean up for $200 and would rather sell. Suppose they agree on a price of $300 per permit. A cuts all the way to 20 tons, removing 80 tons at $200 each, which costs $16,000, and sells its 40 spare permits to B for $12,000. A’s net cost is $4,000. B cuts nothing and spends $12,000 on permits. The total real cleanup cost is $16,000, not $28,000, and the state still gets exactly 120 tons.

That is the whole appeal. The cap sets the total; the trade finds the cheapest way to hit it. Firms that can clean up cheaply profit by doing extra, and firms that cannot pay them to do it. The United States used this design in the 1990 Clean Air Act Amendments to cut sulfur dioxide, the main cause of acid rain, from power plants, and emissions fell well below the cap at lower cost than many had predicted. Critics worry about who gets the permits for free, about firms gaming the market, and about pollution concentrating near plants that buy permits. Supporters answer that the cap is a hard number, which a tax cannot promise.

A slice of pizza is a private good. If you eat it, nobody else can, and a shop can keep you from taking it until you pay. Economists say pizza is rival and excludable. National defense is the opposite. When the country is protected from attack, one more person living in it is protected too, at no extra cost: defense is non-rival. And there is no way to protect the country while leaving out the family that refused to chip in: defense is non-excludable. A good with both properties is a public good.

Think about a lighthouse in the 1800s, the textbook example. Its beam warns every ship that passes, so one ship’s use of the light does not use it up. And the keeper cannot switch the beam off for ships that did not pay. A private company that built a lighthouse and tried to charge would find captains simply using the light and sailing on. So no company builds one, even though the ships together would gladly pay far more than it costs. That is the market failure: a valuable good that no seller can profit from. In practice, governments built and ran most lighthouses.

Most goods are somewhere between pure private and pure public. A city street is non-excludable but becomes rival when it is jammed. Cable TV is non-rival but excludable, because the company can scramble the signal for non-payers. The pure public goods that markets truly cannot supply are a short list: defense, basic scientific research, clean air, the court system, flood control, and knowledge such as a weather forecast that anyone can hear on the radio. For these, the standard answer is for the government to provide them and pay through taxes, which is a way of forcing everyone who benefits to contribute.

A neighborhood of 1,000 homes wants a Fourth of July fireworks show that costs $5,000. Ask each household what the show is worth to them, and suppose the honest average answer is $10. The show is worth $10,000 to the neighborhood and costs $5,000, so it clearly should happen. A volunteer goes door to door collecting $5 from each home. Here is what she hears: ’I would love to see it, but I am a little short this month. You will get enough from the others.’ She collects $1,800. No show.

Every household that answered that way was being a free rider. Fireworks light the whole sky; a family that pays nothing sees exactly the same show as one that paid $5. So each family’s best move, thinking only of itself, is to let the neighbors pay. When everyone reasons the same way, the show does not happen and every family loses $10 of enjoyment to save $5. The free-rider problem is the reason public goods fail in the market: the goods are non-excludable, so voluntary payment falls short.

The usual solution is to replace voluntary payment with a required one. A town council can put $5 on every property tax bill and fund the show, which is what happens with roads, police, courts and defense. Taxes are, in this sense, the price of public goods, collected from everyone because everyone benefits. Voluntary methods work too for small groups where people know each other, and charities and public broadcasting survive on donors who choose not to free ride. But the larger the group, the easier it is to hide, and the more a public good depends on a required payment.

A lake holds a fish population that anyone may catch. Here is a labeled example of what happens as boats are added. One boat catches 100 fish a week. Two boats together catch 180, so 90 each. Three catch 240 total, 80 each. Four catch 280, 70 each. Five catch 300, 60 each. Six still catch 300, 50 each. Every extra boat crowds the others and thins the fish, so the total grows more slowly and then stops. Suppose it costs the equivalent of 55 fish a week to run a boat.

Look at the choice from one fisher’s point of view. He asks whether his boat’s catch beats 55. With five boats, each gets 60, which beats 55, so a fifth boat goes out. A sixth would get only 50, so it stays home. The lake ends up with five boats. Now look at it from the lake’s point of view. The third boat raised the total from 180 to 240, adding 60 fish, more than its 55 cost. The fourth added only 40 fish, and the fifth added 20. Those last two boats each cost 55 and added less than that. They were profitable to their owners only because they took fish away from the boats already there. The lake would be best off with three boats. Open access gave it five.

The biologist Garrett Hardin named this pattern the tragedy of the commons in 1968. The same logic empties ocean fisheries, cuts down shared forests, crowds highways and overpumps groundwater. It is a negative externality with a twist: the victims and the polluters are the same group of people. The fixes are the ones you already know. Assign property rights, so an owner has a reason to protect the resource. Limit access with quotas, licenses or seasons, which is what fishing regulators do. Or charge a fee for use, like a toll on a crowded road. Each turns an unowned resource into one that somebody has a reason to keep.

Suppose used cars of one model come in two kinds. A well-kept car is worth $10,000 and a badly kept one, a lemon, is worth $4,000. Half the cars on the lot are each kind. The seller knows which is which. The buyer cannot tell; both cars are shiny and the salesman says both are great. What should a buyer offer? If she cannot tell them apart, a car is worth about the average, $7,000, to her. So that is what buyers offer.

Now watch the owners of good cars. They know their car is worth $10,000 and they are being offered $7,000. Many refuse to sell. The owners of lemons, offered $7,000 for a $4,000 car, sell eagerly. So the cars that actually change hands are mostly lemons. Buyers learn this and lower their offers, which drives out even more good cars. In the extreme, only lemons trade, at $4,000, and everyone who owned a good car and wanted to sell it is stuck. The economist George Akerlof described this in 1970, and the idea won a Nobel Prize. It is called adverse selection: when one side knows more, the market attracts the worst goods.

The same problem appears in insurance, where the buyer knows more about her health than the insurer, and in hiring, where the worker knows more about his effort than the boss. The fixes all work by moving information across the gap. Warranties let a seller with a good car prove it, because a lemon seller cannot afford the repair promises. Inspections, vehicle history reports and reviews let buyers learn. Laws that require disclosure, from food labels to lemon laws for cars, force the informed side to share. Where information cannot be shared, markets shrink or vanish, which is why imperfect information counts as a market failure.

The United States has a mixed economy: markets make most decisions, and government does a set of jobs that markets do badly. Economists generally list six. First, the government defines and enforces property rights through courts, police and contract law. A market cannot work if you cannot be sure the bike you bought is yours. Second, it provides public goods: defense, courts, roads, basic research, weather forecasts. Third, it corrects externalities with the taxes, rules and permits from this chapter, including the Environmental Protection Agency’s limits on air and water pollution.

Fourth, it protects competition. When one firm controls a market, it can raise prices and cut quality, so antitrust laws since the Sherman Act of 1890 have limited monopolies and blocked some mergers; the next unit takes this up in detail. Fifth, it redistributes income. A market pays people what their work is worth to buyers, which can be very little for the sick, the very young, the very old or the unlucky. Programs like Social Security, Medicaid and food assistance transfer income from those who have more to those who have less. Sixth, it stabilizes the economy, using taxes, spending and the Federal Reserve’s control of interest rates to soften recessions and restrain inflation, which is the subject of the grade 11–12 course.

Every one of these jobs is paid for with taxes, and taxes have costs of their own. So each job invites a question about size: how much defense, how strict a pollution limit, how large a safety net. Those are questions that economics can inform but cannot settle, because they involve values as well as numbers. Economists can say what a policy will likely do to prices, jobs and output. Whether the trade-off is worth it is a question for voters.

A market failure shows that a market has produced the wrong amount. It does not prove that government will do better. Economists use the term government failure for the ways public action can also go wrong. The first is information. To set the Riverton tax at exactly $4, the state has to know the damage per ton. In real life the number is uncertain and contested, and a tax set at $1 or $9 gets the amount of paper wrong in the other direction. Markets pool the knowledge of millions of buyers and sellers in a price; a regulator has a staff and a budget.

The second is incentives. Officials respond to voters, and to organized groups more than to scattered ones. A subsidy that gives $100 million to 1,000 farms is worth fighting for if you are one of the farms, and not worth a letter if you are one of 300 million taxpayers paying 33 cents each. This is why rent-seeking, spending effort to win favors from government rather than to produce something, is a permanent feature of politics. Price controls from the last chapter often survive not because they work but because the people they help are visible and the people they hurt are not.

The third is unintended consequences. Rent control was meant to make housing affordable and shrank the housing supply. A rule requiring expensive safety gear on small businesses can push their work into the black market where there is no safety at all. None of this means government should do nothing about the mill or the lake. It means the comparison is never between an imperfect market and a perfect fix. It is between an imperfect market and an imperfect government, and the honest economist asks which imperfection is smaller in the case at hand.